Question

Derrick Iverson is a divisional manager for Holston Company. His annual pay raises are largely determined by his division's return on investment (ROI), which has been above 20% each of the last three years. Derrick is considering a capital budgeting project that would require a $3,800,000 investment in equipment with a useful life of five years and no salvage value. Holston Company's discount rate is 16%. The project would provide net operating income each year for five years as follows: $3,200,000 1,350,000 1,850,000 Sales Variable expenses Contribution margin Fixed expenses: Advertising, salaries, and other fixed out-of-pocket costs Depreciation Total fixed expenses Net operating income $ 670,000 760,000 1,430,000 $ 420,000 Click here to view Exhibit 128-1 and Exhibit 128-2, to determine the appropriate discount factors) using tables. Required: 1. Compute the project's net present value 2. Compute the project's simple rate of return. 3a. Would the company want Derrick to pursue this investment opportunity? 3b. Would Derrick be inclined to pursue this investment opportunity? Complete this question by entering your answers in the tabs below. Req 1 Reg 2 Reg 3A Reg 38 Compute the project's net present value. (Round your final answer to the nearest whole dollar amount.) Net present value

Answer 1

Reg 1 Net present value $ 63,556 Net operating income Add: depreciation Net annual cash inflow from the project (A) Present Value Annnuity Factor (PVAF) @16% for 5 years (B) Present value of the expected cash flows (C) = (A) X (B) 4,20,000 7,60,000 11,80,000 3.2742 38,63,556 Net Present Value (NPV) = Present value of the expected cash flows - Present value of invested cash = 3,863,556 - 3,800,000 = $ 63,556 Reg 2 Simple rate of return 11.05% Simple rate of return = Annual Income (Initial Investment - Salvage Value) 4,20,000 38,00,000 11.05% Reg 3A Yes, Derrick Iverson will pursue the investment since the NPV is positive. Reg 3B Yes, Derrick Iverson will incline to pursue the investment because simple rate of return is 11.05%.

PVAF Table Time Period 2 3 5 6 7 8 1% 2% 3% 14% 15% 16% 1.97039506 1.94156094 | 1.9134697 1.646661 1.6257091.605232 2.94098521 2.88388327 | 2.82861135 2.3216322.283225 2.24589 4.853431244.71345951 4.57970719 3.4330813.3521553.274294 5.79547647 5.60143089 5.41719144 3.8886683.7844833.684736 6.728194536.471991076.23028296 4.288305 4.16042 4.038565 7.65167775 | 7.32548144 | 7.01969219 4.6388644.487322 4.343591